Getting away from debt vs. Filing bankruptcy

Getting out of debt, also known as default, may seem like your best option if you’re struggling to keep up with your bills. However, getting rid of your debt will not solve all of your problems; the lender can always try to sue you for the remaining amount or sell the loan to a collection agency. If you want to wipe the slate clean, bankruptcy could be a viable alternative.

What is the difference between default and bankruptcy?

Defaulting on a loan means you’ve broken the promise or cardholder agreement with the lender to make payments on time. Each lender has their own requirements on how many missed payments you can have before they consider you in default. In some cases, this can be as little as one missed payment or up to nine missed payments.

Filing for bankruptcy is a legal process that involves making a list of your debts and assets and finding a way to settle those debts. A judge will decide whether any of your debts can be discharged and whether your assets will be used to pay off the outstanding balance. The judge will also decide what property you are allowed to keep and what can be taken away from you.

Default and bankruptcy usually go hand in hand. Many borrowers default on their loans and then file for bankruptcy.

What happens when I default on my loan?

When you default on a loan, the debt will often be sold to a collection agency, who will then attempt to collect the amount owed. The lender may also try to sue you to garnish your paycheck or even try to put a lien on your house to recoup some of the profits when you sell the house.

The type of action taken against you largely depends on whether your debt is secured or unsecured. Secured debt uses your asset as collateral, which can be taken back in the event of default. For example, if you default on a car loan, the lender will often try to repossess the vehicle.

Unsecured debt, like credit card debt, is unsecured; in these cases, it is more difficult for a collection agency to collect the debt, but the agency can still sue you and attempt to place a lien on your house or garnish your paycheck.

A default will also cause your credit score to drop dramatically, ultimately staying on your credit report for seven years. A default could make it very difficult to qualify for another loan or credit card.

What happens when I file for bankruptcy?

Filing for bankruptcy after your default can protect your assets from foreclosure by the lender or creditor.

In a Chapter 7 bankruptcy, the court will decide which of your assets to sell in order to pay off your creditors. Any remaining debt will be paid with the exception of student loans, child support, taxes and child support. This type of bankruptcy will stay on your credit report for 10 years.

If you file for Chapter 13, you may be able to keep more of your assets while paying off some of your debts. Debt that is not paid will be subject to a three to five year repayment plan. This will stay on your credit report for seven years.

Your credit score will likely drop significantly if you file for bankruptcy – by at least 130 points, but sometimes as much as 200 points or more. If you work in an industry where employers check your credit as part of the hiring process, it may be more difficult to find a new job or be promoted after bankruptcy.

Jay Fleischman of Money Wise Law says that if you have credit cards, they will almost always be closed as soon as you go bankrupt. Getting another loan or another credit card will also be very difficult early on after bankruptcy. But over time bankruptcy will affect your score less and less if you are responsible for your credit.

If you are considering bankruptcy, it is a good idea to speak to a bankruptcy lawyer. They can advise you on the best options for your situation, what type of bankruptcy is best for you, and how to protect your assets, such as your home or future income. Fleischman says he often talks to people who have exhausted their nest egg trying to pay off debt before filing for bankruptcy, not realizing that bankruptcy courts rarely affect your retirement accounts.

Should I declare bankruptcy or default on my loan?

Defaulting on a loan and filing for bankruptcy are not opposing choices. In fact, Fleischman recommends that you default on a loan before declaring bankruptcy. If you haven’t defaulted, it may indicate that you haven’t given yourself enough time to allow your financial situation to improve.

If you default, filing for bankruptcy can protect your assets from foreclosure by creditors. It can also protect you against garnishment of future wages or an inheritance. “Bankruptcy is useful not only for protecting what you have, but also for protecting your future,” says Fleischman.

Other options for dealing with debt

Default and bankruptcy aren’t inevitable if you’re having trouble paying off your debt – there are strategies that can help you get going.

Balance Transfer Credit Card

If you have credit card debt on a card with a high APR, try transferring the balance to a card that offers an introductory 0% APR. This allows you to pay off the balance without having to pay interest.

Most of these special APR offers last between 12 and 20 months, depending on the terms of the card. After the special offer ends, a regular interest rate will go into effect, so it’s best to make as many payments as possible during the introductory period.

Debt Consolidation Loan

A debt consolidation loan is a personal loan that you use to pay off other debt, usually credit cards. Debt consolidation loans generally have low fixed interest rates and terms ranging from one to seven years. Since debt consolidation loans generally have lower interest rates than credit cards, they are a cheaper way to pay off high interest credit card balances.

Medical debt negotiation

If you have medical debt, you may be able to significantly reduce your monthly payments. Call the billing office, explain your financial situation, and try to negotiate a lower monthly payment. Many hospitals offer back-up plans and discounts for financial hardship. If you are looking for help, you can also hire a medical bill negotiation company.

Student loan hardship options

If you’re struggling with student loan debt, know that bankruptcy won’t fix that debt. However, there are options to make your payments more manageable.

Borrowers with federal student loans can choose to continue with the deferral or forbearance for up to three years in total. Depending on the type of student loans you have and the type of relief you choose, interest may still accrue during this time. Until September 30, 2021, all student loans held by the federal government are automatically forborne with no accrued interest.

Another option for federal borrowers is to switch to an income-based repayment plan with a loan forgiveness option. This will extend your repayment schedule, but because the plan bases your student loan payments on your actual income, your monthly payment can be as low as $ 0.

If you have private student loans, you may still be eligible for deferral or forbearance options. It depends on the lender; if you are having financial difficulty, call your lender and ask what your options are.

Next steps

If you haven’t yet defaulted on your loans, you still have time to consider other options. Your first step should be to contact all of your lenders and bill providers and explain to them that you are having difficulty with monthly payments. Finding a lower rate, deferral, or special payment plan can save you from default or bankruptcy in the future.

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